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FOUNDER LIABILITY
THE HIDDEN TRAP
INTRODUCTION
Founders have the odds stacked against them. While many founders dream of building the next successful “unicorn,” only a select few succeed. Beyond the steep rate of failure, when founders begin a new business, they take on a tremendous amount of personal financial risk. And, for a variety of reasons, founders aren’t fully aware of how exposed they really are.
Technology Startups fail at greater rates than the general population of U.S. service-based (professional) small businesses. Startups are twice as likely to fail than to succeed, which is a sobering fact for most founders [1,2].
[1] U.S. Service Business data from U.S. Census Bureau.
[2] Technology startup data failure rate based on startups that failed to return 1x< on venture financing per Kramer, B., & Patrick, M. (2014). Trends in terms of Venture Financings in Silicon Valley. (pp. 3-4). Mountainview: Fenwick & West LLP.
Startup Failure Rates
THE PRICE OF PERSONAL GUARANTEES
THE HIDDEN CLAUSE
Failure isn’t the only risk that founders take. When founder Eddie Lim sold one of his first companies, his business credit card debt was not on the top of his mind. As he transferred the business to its new owners, he didn’t realize the potential risks of transferring a business credit card in an acquisition.
As Eddie puts it: “One day, four months after the sale, both my wife's and my primary personal credit card stopped working, while we were traveling.” After digging deeper, Eddie realized he had several personally guaranteed business credit card bills pending payment. Those bills had not been paid and were delinquent, so the credit card company shut off his personal credit cards. As Eddie puts it, “To the greatest degree possible, avoid putting down a personal guarantee. You never know when it can come back and bite you.”
Eddie isn’t alone in this experience.
But to understand how this happened to Eddie and thousands like him, first, let’s look at the terms of a personal guarantee.
HOW DO PERSONAL GUARANTEES WORK?
A personal guarantee is a commitment to transfer ownership of one’s personal assets (such as a house or car) to cover a debt (such as a credit card loan or other financing). Personal guarantees grant financial institutions the right to seize founders’ personal assets to pay off debts.
Personal guarantees are very common in small business financing. In fact, 87% of businesses reported using personal credit scores to obtain financing according to a recent 2017 Federal Reserve study [3].
[3] United States. Federal Reserve Board. (2018). 2017 Small Business Credit Survey; Report on Employer Firms; 2018 report. https://www.newyorkfed.org/smallbusiness/small-business-credit-survey-2017
WHAT DOES THIS MEAN FOR FOUNDER LIABILITY?
Founders often don’t know that they’ve placed their personal assets on the line in exchange for business credit card financing because banks often neglect to bring it to their attention. Banks bury “personal liability” clauses in pages and pages of terms and conditions.
To verify this finding, Brex tested the sign-up processes for business cards from a group of banks including American Express Business OPEN, Chase Ink, and Capital One Spark. In each case—personal guarantees were nestled among clauses at the end of credit card disclosures and account terms—a place where they are almost sure to be missed.
To the right are part of the American Express Terms & Conditions. Note the red box for hidden, opaque language ascribing founder liability.
Terms and Conditions
important numbers
checks graph
This can have dire consequences for founders. In fact, up to 60% of startup founders that use credit cards for their business could see personal assets worth up to $51,000 seized to pay for credit card debt alone.
On the left, founder liability is broken down by liability type and card product [4].
[4] Tsosoie, C. (2017, April 17) Do Business Credit Cards Affect Your Personal Credit Score? https://www.nerdwallet.com/blog/credit-cards/qa-business-credit-cards-affect-personalcredit-score/, Credit Karma, Company Websites, Terms & Agreements
[5] Brex early stage founders credit card switching data. Base population: founders who used credit cards before Brex.
[6] Early stage founders, both Brex and non Brex, surveyed by Brex staff (N=30)
[7] 3-month average for Brex early stage founders.
Credit Score Effect Graph
Simply applying for a credit card (when linked to a personal credit score) can also decrease credit scores by 5 points per application [8]. Despite this, because all of the cards available to startups are focused on mom-and-pop businesses, they each require founders to use their personal credit score.
While a five-point decline on a good credit score may seem trivial, the consequences of delayed payment or default can be much more significant. For example, if a credit card isn’t paid on time, a founder with a credit score of 780 (which is close to perfect) could see his/her credit score fall by over 100 points. In addition, failure to pay credit card bills in a timely manner can remain on personal credit reports for up to seven years.
[8] Credit Checks: How Credit Report Inquiries Affect Your Credit Score. (2018). https://www.myfico.com/credit-education/credit-checks/credit-report-inquiries/
[9] Can one Late Payment Affect My Credit Score?” Equifax Finance Blog, Equifax, 7 Feb. 2014, https://blog.equifax.com/credit/can-one-late-payment-affect-mycredit-score/
[10] Credit Report Q&A – Effects of Credit Missteps. (2018). https://www.myfico.com/credit-education/questions/credit-problem-comparison
FOUNDERS OFTEN THINK THIS WON’T AFFECT THEM
As we saw with Eddie, founders often don’t know how personal guarantees will affect them in the long run. However, sometimes personal guarantees do not only affect your long term credit, but your ability to get credit at all.
Take Victor Santos for example, who moved to the United States from Brazil at a young age. As an immigrant with no credit score and parents who could not guarantee his credit, Victor couldn’t find a bank that would approve a small business card without requiring a security deposit.
As Victor puts it: “Picture yourself in my position—I was very young, in a different country, trying to start a business and could not get approved for a card like everybody else. Why? Because I did not have a personal credit score a bank could look at.”
Not qualifying for a credit card without putting down a substantial security deposit posed a major challenge for Victor. He needed a card to pay for the software, servers, and computing power startups need to run their business. Without a credit card, there was simply no way he’d be able to get his business off the ground and eventually scale.
A RISK FOUNDERS DON’T HAVE TO WORRY ABOUT
As we’ve seen, startup founders are assuming a high degree of risk when they launch their startups. Making matters worse, traditional banking, and lending institutions have created additional hurdles for startup founders to gain access to capital.
But it doesn’t have to be this way. Brex is leveling the playing field by creating the first corporate card for startups. As a startup, Brex has encountered the same difficulties as other founders and knows firsthand the roadblocks in acquiring credit.
With that in mind, Brex has disrupted the conventional credit model. By rebuilding the technology from scratch, they’ve reimagined underwriting so it doesn’t require personal guarantees. Brex assesses companies based on factors that matter – like cash in the bank and activity in the business – and can avoid using the outdated, non-transparent, and potentially biased personal guaranteed approach.
In doing so, Brex ensures founders and their credit scores are not exposed to added risk at one of the riskiest junctures in their lives—starting a company. The new face of credit ensures that founders have access to capital at the most crucial time, without the hidden clauses.